On a Boil

The aroma of a scented soap is a world away from the pungent smell of petrol and diesel. Yet, many analysts on Dalal Street are nowadays comparing oil marketing companies (OMCs) with fast moving consumer goods (FMCG) players. There are several reasons for this.

FMCG companies are a favourite of stock markets due to pricing power, predictable margins, stable returns and regular dividends. OMCs, also called downstream oil companies, too, have been showing these traits of late. As the energy sector becomes more stable due to low crude oil prices globally and deregulation/reforms at home, the companies are now behaving more like stable and less like cyclical businesses. This, of course, does not mean that they do not have their peculiar risks.

Government-owned OMCs - Indian Oil Corporation (IOC), Hindustan Petroleum Corporation (HPCL) and Bharat Petroleum Corporation Ltd (BPCL) - have done exceptionally well over the past few years. Now, with the government lining up more reforms (such as gradual increase in kerosene prices to make them closer to market rates ) in the oil sector, and structural changes kicking in, it is a good idea to see if it makes sense to invest in these growth stocks at this juncture.

The Changes

Debashish Mishra, Partner, Deloitte, says a lot of fundamental changes have taken place in the energy sector over the past few years. One, OMCs are no more burdened with losses they used to make by selling products at below market prices. Prices of jet fuel were deregulated in 2002, that of petrol in 2010, and diesel in October 2014. This has led to a significant de-leveraging of balance sheets. "Free pricing has kicked in. This has improved the cash flow/working capital situation and lowered debt. Interest costs, too, have come down. All this has been made possible by falling crude oil prices," says Mishra.

Will OMCs fuel your investment portfolio?

While it is never difficult to find skeptical voices on Dalal Street, a large number of analysts are bullish on OMC stocks. They are happy with the way the business is playing out and say there is a lot of room for earnings to grow.

1) Robust demand: Petroleum consumption in India rose at a compounded annual growth rate (CAGR) of 7.6 per cent between 2013/14 and 2015/16, led by petrol (12.9 per cent), LPG (9.5 per cent) and Naphtha (8.9 per cent), according to government data.

"We expect demand for petrol to remain strong on the back of higher automobile sales, pick-up in infrastructure investments and recovery in industrial production," says Amar Ambani, Head of Research, IIFL. India's robust economic growth is likely to boost the demand for diesel, especially from the transportation industry. This year, the demand for petroleum products is expected to rise 5-6 per cent.

2) Lower crude oil prices: Crude oil prices have dropped from $106 a barrel in July 2014 to $42 per barrel in September 2016. This has benefited OMCs immensely. This has not only reduced their working capital requirements (leading to lower interest costs) but also brought down operating costs for refineries.

3) Reduced debt: Combined debt of the three OMCs was Rs 1,38,705.2 crore in 2013/14. It fell to Rs 81,797.9 crore in 2015/16. Interest costs also fell as companies did not depend much on short-term borrowings for working capital.

4) Gross Refining Margins (GRMs): Rise in GRMs has improved bottom lines of the companies. Analysts expect GRMs to remain stable. They say higher refining and fuel efficiencies are expected to reduce the gap between Indian and Singapore GRMs - the latter are considered a benchmark. For example, IOC's recently-commissioned Paradip refinery, which would become operational this year, would increase GRMs its by $1-2 per barrel.

5) Marketing margins: There is hope that marketing margins will increase, though nominally (after the price deregulation, they have increased by 20-30 paisa per litre). The reason brokerages are not expecting a sharp increase is that OMCs are using marketing margins as a tool to fight competition from private players. The three OMCs, which between them own 55,000 fuel stations, have automated their set-ups for better product quality and inventory control. Being integrated players (that are into both refining and marketing), they have the advantage of offsetting fall in refining margins in case of future inventory losses by expanding marketing margins. However, if differential pricing is introduced in areas that have a shortage of fuel stations, it could bring the companies better returns.

6) Dividend Payout: Government policy requiring public sector companies to pay 30 per cent annual profit as dividend makes OMCs attractive for retail investors (for whom dividend income up to Rs 10 lakh is tax free). In 2015/16, while HPCL and BPCL distributed 35 per cent profits as dividend, IOC returned shareholders 38 per cent of its total profit.

These factors could bring good tidings for the three OMCs. Experts expect a CAGR of 10-15 per cent over the next three years. Ambani of IIFL says Indian OMCs are much better placed compared with global commodity companies due to strong demand, improving financial health, increasing efficiency of refineries and limited competition from private players. Hence, they can be assigned a premium to the global average multiples, he says.

"While buying on dips (if they arise) is a sound strategy, we would recommend buying these stocks even at current levels. They are trading at the 2017/18 P/E multiple of 9-10 times, which is not expensive in our view," he says. However, some analysts warn against too much bullishness. They give the following reasons.

1) The shares have rallied sharply of late. For investors with less risk appetite, this could pose a risk in the near term as the stocks seem slightly overvalued. Between August 1, 2014, and September 2016, when crude oil prices fell 59 per cent (from $104 per barrel to $42 per barrel), HPCL has rallied 199 per cent, BPCL 103 per cent and IOC 73 per cent. However, they still seem good bets for the medium to long term.

2) Some say the optimism needs to be tempered due to difficulty in increasing marketing margins. Brokerage firm Ambit Capital says in a report that the margins did not go up even when crude oil prices fell from $70 in December 2014 to $32 in January 2016. It is, therefore, unlikely that they will rise at a time when upward pressure on crude oil prices can make passing on the increase to consumers itself a challenge.

3) Though the cash flows of OMCs are healthy as of now, will they be able to invest the capital available in the best possible projects? While IOC is working on a capex of Rs 1.8 lakh crore, the figures for HPCL and BPCL are also quite high (Rs 55,000 crore and Rs 45,000 crore, respectively). There is a doubt if these investments would translate into good returns for equity investors.

Deepak Mahurkar, Leader, Oil & Gas Industry Practice, PwC India, flags another concern. "We haven't seen private players aggressively participating in retail expansion of outlets and this is perhaps a vote of no-confidence in the present government. They need assurance that deregulation will not be rolled back and perfect GST will apply soon," he says. So, will the government go back to regulating prices if crude oil rises to, say, $80 per barrel? It's a question that only time can answer.

Not just this. Mahurkar says there is scope to make the fight for fuel pricing healthier. At present, all OMCs sell at standardised prices. This is unlike in the global market where players have different pricing strategies, leading to healthy competition.

So, even if the OMC business has become less cyclical, only the brave on Dalal Street can call OMCs quasi-FMCG players. However, those who believe that the market pays for growth and risk can go ahead and invest.